Rate rise likely as fears dispel

Easing fears of a double-dip recession in the United States this year, and increasing hopes of a soft landing for the Chinese economy, are likely to mean the path has been cleared for the Reserve Bank of Australia to raise official interest rates at tomorrow’s policy meeting.

The RBA might well have raised interest rates last month after stronger than expected June quarter national accounts and a large rise in business investment intentions, but seems to have hesitated due to an upsurge in fears about the US economy.

According to the minutes of the September RBA policy meeting, the board considered “there had been no significant change in the overall outlook, with conditions looking a little stronger domestically than they had at the previous meeting, but looking a little weaker internationally". In particular, it noted an “increase in concerns over the past month about the outlook for the US economy and government debt in some European countries".

The world MSCI equity index fell 3.6 per cent through August, but global economic conditions have changed for the better, at least marginally, over the past month.

AFR
AFR

Weekly US jobless claims have corrected their earlier worrying rise, and the manufacturing sector has continued to grow. US housing demand rebounded modestly, and the US Federal Reserve has also promised to drive down long-term interest rates further if need be to underwrite the economy.

The critical bottom line is while US economic growth in the September quarter is likely to be modest, keeping unemployment high, it should at least not turn negative, which could have raised fears of a slide back into recession.

In China, meanwhile, activity indicators suggest the economy is still humming along, even while selective credit tightening measures are trying to dampen rampant property speculation in major cities. The economy grew by 10.3 per cent in the year to June, and it was reported last week that China’s purchasing managers survey for manufacturing rose by more than expected, to 53.8, in September.

And after a worrying August, the world MSCI equity index rebounded 4.1 per cent in September.

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The RBA has been at pains to stress in recent years that it has a less US-centric view of the global economy these days – it is taking great solace from the continued strength in Asian economic growth, underlaid by Asian domestic demand, even while the world’s largest economy splutters forward.

Of course, there’s a chance the RBA will hold off on any decision to raise interest rates until November following the release of the September quarter consumer price index results later this month. Underlying inflation has been easing over the past year broadly in line with RBA expectations.

And in the minutes to the July policy meeting, the Bank flagged its desire to hold off on a decision to raise interest rates until after the June quarter CPI results were released later that month.

As it turned out, the June quarter CPI results were quite good, with underlying inflation rising by only 0.5 per cent in the quarter. This encouraged the bank to keep rates steady in August, while – as noted above – renewed global jitters encouraged it to keep rates steady in September also.

But the upshot is that official interest rates were last increased in May – some five months ago – even though the bank has kept a moderately warm bias to raise interest rates further.

Notably, this time around, the rhetoric from the RBA has not pointed to the coming CPI results as being particularly important for near-term interest rate decisions. It suggests the RBA does not feel the need to wait for the next CPI before acting.

In large part, the RBA probably feels the decline in annual underlying inflation has already bottomed out – at about 2.75 per cent – and policy settings now need to be geared towards capping the expected rebound in inflation over the coming two years.

Even before the stronger than expected June quarter economic growth results were released – and before the upgrade to business investment intentions in the June quarter official capital expenditure survey – the RBA was forecasting annual underlying inflation to hit 3 per cent again by the June quarter 2012.

And even that forecast anticipated at least one to two interest rate increases over the coming year.

Following the upbeat national accounts and investment reports, chances are that the RBA has recently upgraded its growth and inflation forecasts further, suggesting underlying inflation would clearly breach to the top half of its target band by late next year without near-term policy tightening to slow the economy. That’s the justification required for taking the next step of moving interest rates from a “neutral" to somewhat “restrictive" setting.

What’s more, although there are upside and downside risks to this economic forecast – with inflation already near the top half of the target band and unemployment already quite low, the RBA is likely to judge that the cost of tightening too slowly would be greater than the cost of tightening too quickly.

The cost of acting too slowing would be to push inflation well above the 2 to 3 per cent target band, and overly tighten an already tight labour market.

But the cost of acting too quickly might only mean a greater chance of inflation staying within the target band, whilst leaving the unemployment rate still reasonably low.

A further interest rate increase risks placing more pressure on the housing sector, which already seems to be cooling due to low affordability and development constraints.

But with other areas of the economy strong, housing – potentially along with consumer spending – may be forced to bear the burden of adjustment to keep the inflationary effects of our mining and public infrastructure boom under control.